Portfolio Management and Second-order Greeks

Demetri Papacostas and Francesco Tonin

The previous chapter armed us with powerful tools that enable us to peer into the heart of option valuation and option risk management. These tools can be complex in their own right, but they get very challenging with the awareness that to get anywhere you need to consider all of them at once. However, there is one key characteristic that allows us to breathe easier – the results of each analytical tool can simply be added across many options. As we saw in Exercise 9.1, this allowed us to engineer portfolios that react a certain way to market conditions. That is powerful! In this chapter, we will take the closing realisations from the previous chapter and build on them. We will begin by examining the greeks and issues of a particular combination of options, called the “risk reversal”. As a consequence of that analysis, we will examine the market conventions around the risk reversal, and its impact in a portfolio setting. As we’ve done before, as the chapter progresses we will ratchet up the complexity to include other tools that are helpful in portfolio management.

OPTION PORTFOLIO MANAGEMENT: THE THEORY AND THE REALITY

Recall the situation we introduced back in Chapter 8